Public sector bond market participants have their sights permanently trained on the US Federal Reserve, watching for any hints as to the direction of the US Federal funds rate. After eight years without a move, the Fed has recently lurched between hawkish and dovish with a rapidity that has wrong-footed many investors.
Now that the US trade war with China is dragging on global growth, the tone of the investor community has shifted from expecting rate hikes to calling for, and pricing in, further cuts to shore up the economy.
At the end of 2018, the market expected US interest rates to climb throughout 2019 and that Treasury yields would be substantially higher. Forecasts put 10 year US Treasury yields at over 3%, but throughout 2019, they have ground lower and lower — at one point dipping below 1.5%.
This dovish shift has worked in the favour of the SSA borrower community in 2019. “Investors have had to supplement US Treasury yields with SSA spreads, especially at the short end of the curve,” says Sean Taor, head of DCM and syndicate at RBC Capital Markets in London.
Indeed, since they can pass on their cost of funds, another cut here or there does not matter as much as stability and conviction on the direction of travel. Sadly, stability and conviction are expected to be in short supply in 2020.
While the president does not control the Federal Reserve’s rate policy, he has not been shy about ramping up the pressure on Federal Reserve chair Jerome Powell to cut rates.
However, if Trump is successful in negotiating some kind of ceasefire with China in the trade war, and global growth picks up, the improvement in the US’s economic outlook might provoke the Federal Reserve to hike rates.
US unemployment is low, and economic growth, though slowing, is ahead of expectations. “If the uncertainty around trade were suddenly resolved, then we may have some meaningful revisions ahead,” says Lee Cumbes, head of public sector DCM at Barclays.
Taor agrees, remarking that the “market may have got ahead of itself, as the US economy is still relatively strong. I think the market is pricing in too much in the way of ongoing rate cuts.”
Not everyone is so confident. James Athey, senior portfolio manager at Aberdeen Standard Investments, believes that the slowdown in growth is a secular trend tied to the slowing Chinese economy.
“It has become received wisdom that the weakness in manufacturing stems from trade, but really it goes back far longer than the trade dispute,” he says. “It’s China’s domestic policy choice to accept slower growth, rather than to stimulate its economy with debt.”
Countries like Germany and the US are feeling the slackening in Chinese demand, not simply because of the tariffs, but because China is prepared to accept a slower rate of economic growth. As a result, Athey believes that a truce in the trade war “would not be economically significant”.
If he’s right, manufacturing and growth will continue to slow. While stocks will rally in relief if the trade war is resolved, the confidence boost is likely to be short-lived, if the economic data does not improve, and the Federal Reserve may be forced into more cuts.
With differing views on the US economic outlook, volatility is almost a given as investors move their cash around as their confidence ebbs and flows.
And whether or not the trade war is a significant event for global growth, enough investors will be attempting to speculate on its outcome that it will certainly affect the market as the year develops.
“If more tariffs are imposed, we’ll see that driving volatility and windows will open and close more rapidly,” says Kerr Finlayson, SSA syndicate banker at NatWest Markets in London.
Unattractive levels keep borrowers away
The cross-currency basis swap has kept many euro issuers away from the dollar market, while dollar borrowers enjoyed excellent terms on their euro borrowing.
As a result, SSA dollar borrowing raised only $342bn in 2019, compared to €395.5bn ($437bn) raised in the euro market.
“For euro-based borrowers, the dollar market has been a bit of a tough sell,” says Finlayson. “The basis has continued to grind lower and, unless you’re a big issuer that needs to maintain a presence there, the cost advantage just isn’t there at the moment.”
Olivier Vion, head of SSA syndicate and DCM at Société Générale, agrees, adding that “US Treasuries have been trading close to or above dollar swap rates, which has meant SSAs have had to widen their issuance levels.” That, combined with the unfavourable cross-currency basis swap has meant that many issuers are not issuing any more than they have to in the dollar market
Of course, many borrowers do have to maintain a presence in the dollar market, and those considerations are not going away any time soon. Euro, sterling and niche currency borrowing alone cannot fill the huge programmes of borrowers like the European Investment Bank and KfW.
And for issuers with smaller programmes, it pays to maintain a presence in the dollar market, even at unattractive levels. While the euro market has been offering cheaper funding, it can close down swiftly and without much warning.
In 2019, issuance in the euro market slowed down ahead of September’s ECB meeting.
“That meant there was a big rush of dollar issuance, even when the pricing wasn’t necessarily highly attractive after the swap for euro borrowers,” says Cumbes. “Once the ECB was over and we had more certainty on policy direction, activity in euros picked back up. Still, it demonstrated that issuers need strategic access to both currencies as even the major markets experience periods where they are subdued.”
And with a new ECB president, the lead-up to 2020’s ECB meetings is likely to be even more fraught than usual as investors do their best to speculate on how Christine Lagarde will attempt to steer ECB policy. Borrowers would do well not to rely on the euro market in the weeks leading up to important decisions.
Reaching for the long end
Opportunities at the long end of the dollar curve are typically ephemeral. While issuers are always keen to issue there, demand is driven by “a handful of investors,” according to Finlayson. “It’s a tough maturity at the best of times — windows come and go very quickly,” he adds.
But despite the scepticism around the strength of long end demand, given that rates are historically low, there should be plenty of investors willing to look at the long end of the dollar curve in order to get some pick-up in yield.
The fortunes of SSA issuers at the long end of the curve will rest not on the absolute level of yield available, but on where investors expect yields to move.
That was made clear in 2019. There was almost no issuance at the long end of the dollar curve early in the year when 10 year Treasury yields were yielding around 2.5% or so. But later in the year, in September and October, the market enjoyed a flurry of issuance with 10 year Treasury yields at 1.8%.
The long end opened up because investors were confident that yields, which had dipped to 1.6% only a month before, were going to trend lower. The confidence that this was a temporary high point for Treasury yields gave investors the confidence to buy at 10 years.
That is the same dynamic that will inform the appetite for 10 year dollar paper in 2020. “If yields stay where they are, or go back lower, access to the long end of the dollar curve could be achievable,” says Taor. “But if investors expect rates to climb then in the short term it’ll be more challenging.”
That means that borrowers looking to print 10 year dollars will have to scrutinise investors’ perceptions of the direction of the Federal Reserve’s rates, and their confidence in the US economy even more closely than usual.
If Trump embarks on another round of fiscal stimulus in an effort to stage manage the US economy into a positive, election-winning shape, investors will flood into equity markets to capitalise and rates will rise. “That, short term, will be a challenge for long-dated issuance,” says Taor. “However if yields then stabilise at more attractive levels, then the market will quickly re-open.”
But if no trade war resolution occurs, and manufacturing data weakens, investors will likely pull cash out of the stock market and pile it back into US Treasuries, pushing down rates, potentially opening opportunities for SSAs to offer spread at 10 years and pick up attractive levels on rare 10 year dollar debt. GC
